When an earnings announcement reaches every investor, competing buy and sell orders can incorporate its implications before you place a trade. An analysis can be correct yet offer no remaining trading advantage.
The efficient market hypothesis (EMH) asserts that security prices fully reflect available information. No investor can consistently earn risk-adjusted abnormal returns, after information and trading costs, using information already reflected in prices. Efficiency allows estimation errors and price changes when new information arrives.
Market value is the price at which a security currently trades. Intrinsic value is an analyst's estimate of its underlying worth, based on expected cash flows and the required return. Different assumptions can produce different intrinsic values for the same security.
A stock trading at $48 looks undervalued to an analyst estimating intrinsic value at $55. That $7 gap is an estimate, not a guaranteed profit. Market efficiency concerns how well prices incorporate information, so an analyst's disagreement with the market does not establish mispricing.
Common mistakes
- Misclassifying the information set. Past prices alone test weak form. Public information beyond past market data tests semi-strong form. Private information tests strong form. Trap: selecting "weak-form violation" when a strategy uses 10-K filings (public data beyond prices).
- Reversing the hierarchy. A semi-strong violation does not necessarily violate weak form. If public fundamental information is not fully priced, past prices may still be fully priced. Trap: concluding that technical analysis must work because a public-filings strategy works.
- Ignoring risk adjustment. An anomaly showing 2% annual outperformance might vanish after adjusting for higher beta. The correct answer often acknowledges the anomaly while noting the risk-based explanation. Trap: declaring the market inefficient without considering whether the excess return compensates for risk.
Bottom line
- Market value is the traded price; intrinsic value is an estimate based on cash flows and required return.
- Informed competition, accessible information, and low trading costs support efficiency; trading restrictions can impede it.
- Weak form reflects past market data; semi-strong adds all public information; strong includes private information and is empirically rejected.
- Weak efficiency rules out persistent technical-analysis abnormal returns; semi-strong also rules out public fundamental-analysis abnormal returns after costs.
Exam shortcut
When a question asks which EMH form a strategy violates, underline the information required to run it. Select the narrowest sufficient information set, then carry the violation upward if the question asks about other forms. For event studies, check whether the chart shows raw prices or abnormal returns before interpreting drift. Violations go up, never down.
The full lesson (about 2,308 words, 15 min read) adds 2 worked examples, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- market efficiency
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